The search for yield: The U.S. v. Europe.
Considering the depth and reach of the financial shock of 2008, it is remarkable how quickly the real estate finance markets across Europe and the U.S. have rebounded. Investors keen to take advantage of rock-bottom property valuations and attractive yields have raised amounts of additional capital that are notable given the profound blows to global economies in the wake of Lehman Brothers' collapse.
In Europe, non-bank lenders (NBLs) in particular are in a prominent position in the market, investing in real estate non-performing debt, development finance, and junior debt and equity, much of which falls outside the traditional banks' post-recession lending mandate. As reported in our previous article, there has been a stronger rebound of the traditional banks in the U.S. by contrast to Europe, which has led to many U.S. investors looking across to Europe to invest. The likes of Lone Star, Blackstone and others have growing teams in London, Germany and further afield.
Increasing competition and liquidity are leading to rapidly reducing yields. Let's look at some indicative numbers for Europe: A Savills report suggests that in the UK in 2014 there was PS60bn of capital chasing borrowing demand of PS37bn. In 2007, the spread between the lowest prime yield in a "Big Six" market (Manchester, Birmingham, Edinburgh, Bristol, Leeds and Glasgow -- each regional UK cities some distance from London) and Mayfair (an affluent suburb of "prime" London) was 75bps, according to M&G (an investment fund). Although this spread opened up during the credit crunch (250bps at the end of Q3 2013 according to M&G), evidence towards the end of 2014 show that we are slowly working our way back to the pre-crunch range. Investment yields in the prime London market are now at 4.25 percent to 4.50 percent, according to CoStar, with the landmark Gherkin completing at 4.00 percent in November 2014; while prime yields in UK regional cities stand at around 5.75 percent, according to a mid-2014 CBRE (a property consultant) report.
In addition to the competitive environment, increased regulatory pressures are having the unintended consequence of making returns on "safe" assets so low as to incentivise greater risk. Some junior or mezzanine NBLs, struggling to deliver on their promises of double-digit returns made two or three years ago, are already being priced out of the key city markets and into regional or more unconventional deals.
Although there appear to be no tangible signs of imminent slow-down, there are murmurs of concern that the market will reach its peak in the next six months to a year, if it has not done so already, in London and key European cities. Lending mandates are being stretched so that funding for capital expenditure now accommodates what looks remarkably like development finance, and lenders are looking for deals in regional cities in the UK such as Bristol, Birmingham, Leeds or Manchester, with similar rippling in Ireland, Germany and France.
A similar story is playing out across the hardest-hit European economies. There is interest in markets with greater perceived economic and execution risk such as Greece, Italy, Spain and Croatia (to name a few), which would not have been considered even a few years ago. The avid appetite for the non-performing loan portfolios (Projects Rock, Salt, Pebble, Stone, Sand, etc.) sold by the special liquidators of IBRC (formerly Anglo Irish Bank, an Irish bank) abundantly demonstrates the eagerness of investors to find value in the spread between a discounted purchase price and work-out yield. On the other hand, although there is plenty of interest in Spanish assets, anecdotal evidence suggests that potential vendors are waiting for further capital growth before selling. These geographic quirks mean the ripple effect of competitive pressure will only be fully understood in the medium term rather than short term.
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The U.S. is experiencing analogous competition among lenders and investors. Competition in prime cities, such as New York, is fierce, and spreads for portfolio lenders have been pushed below 3 percent for construction loans and below 2 percent for stabilised assets. CoStar reported that commercial real estate loans by banks in 2014 exceeded the 2007 peak. With respect to CMBS issuance, some groups are forecasting as much as $140 billion of issuance in 2015. Competition among investors has likewise become intense, pushing cap rates to pre-recession lows in New York City. The Real Deal reported 2014 cap rates of 3.4 percent for residential buildings, 4 percent for retail properties and 4.2 percent for office properties. Such competition is forcing lenders to relax loan terms and to look to areas outlying prime cities and to cities in the interior of the country.
CREFC's 2015 Winter Report indicates that CMBS underwriting took a turn for the worse in 2014, with an increase in interest-only loans and loans with underwritten pro forma rents. The number of transactions involving subordinate debt is also increasing, with bridge lenders pushing total loan-to-value to 85-90 percent for attractive assets. Lending in non-prime cities has also steadily been rising. Crain's reported that the New York outer-boroughs could have 100 additional hotels by 2017 and Chicago Real Estate Daily is projecting 2015 commercial property sales to hit their highest level since 2007. There is increasing talk on the street about the U.S. real estate markets approaching a peak. However it is unlikely that the U.S. market will see a slow-down in 2015.
The fundamental theme that is becoming apparent is that NBLs and, to a certain extent, banks, are willing to accept ever increasing levels of risk to achieve the returns currently demanded by investors and shareholders. Is this a positive sign of a robustly growing market or does it merely reflect how short our memories are? What proportion of real estate debt that has either been originated or traded in the last few years, will come back to bite on the next downturn? We look forward to the spectrum of answers that will no doubt be uncovered by this crystal ball-gazing.
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|Publication:||Inside Counsel Breaking News|
|Date:||Feb 20, 2015|
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